Solution to Financial Accounting Theory William R Scott 5th Ch12_solu

Chapter 12S UGGESTED S OLUTIONS1. The firm’s costs of producing information will depend on the nature of theinformation produced. For finer information, costs would arise from reportingextra line items in the financial statements, preparing notes to the financialstatements, and reporting other supplementary information which expandsdisclosure within the mixed measurement model framework.For additional information, such as RRA and MD&A, costs are incurred inpreparation and disclosure. These costs can be quite high, since the additionalinformation requires numerous estimates and forecasts.In both cases, costs could also include proprietary costs arising from release of information to competitors. For example, new entrants may be attracted to theindustry.For more credible information, costs would include, for example, higher fees paid to a more prestigious auditor.For signals, the cost would depend on the signal. If the firm voluntarily disclosesa forecast of next year’s operations, this would be a signal that the firm isconfident about its future. The costs of this signal include preparing andpresenting the forecast, and the expected costs of any penalties or lawsuitsagainst the firm if the forecast, even if made in good faith, turns out to bematerially wrong. Other signals would be the hiring of a prestigious auditor, and presenting more than the minimum amount of financial statement disclosure (the MD&A of Canadian Tire Corporation in Section 4.8.2 is an example). Here, costs include the additional auditing and disclosure costs. It should be noted, however, that signalling costs will be lower for a high-type firm than for a low type.The benefits of information production derive from a feeling by investors that the firm is transparent, that is, it is up-front and candid in revealing information about itself. Again, the Canadian Tire disclosures are an example of this type ofreporting. The benefits could show up in a reduction of the firm’s cost of capital,consistent with empirical results, such as Botosan and Plumlee (2002). Otherbenefits derive from a reduction of the agency costs of contracting. For example, if a firm agrees to include debt covenants in its borrowing contracts, this willlower the costs of borrowing.The firm should produce information until its incremental cost of informationproduction is equal to its incremental benefits. This amount could differ, however, from the socially best information production, due to externalities and othermarket failures.7. a. The adverse selection problem in this context is that persons withvaluable inside information about a firm may take advantage of thisinformation to earn profits at the expense of outside investors. They maydo this by failing to release their information or acting on it beforereleasing it. They can then earn profits from insider trading.b. Financial accounting information can reduce the problem through:x Full disclosure of useful information in the financial statements and notes.x Supplementary disclosure such as MD&A.x Timeliness of disclosure – full disclosure will reduce the scope forinsider profits to the extent the disclosure takes place soon after theinside information is acquired.c. It is unlikely that financial accounting information can completely eliminatethe problem. This would be too costly, since some information is proprietary.Also, continuous disclosure of all useful information would be necessary.d. Market forces may reduce the problem. If the issuer, or other insider, isrevealed to have engaged in insider trading, the issuer’s cost of capital will riseand reputation will be harmed, particularly if there is media publicity.Other forces derive from regulations, such as legal penalties, regulationsrequiring information to be released to all parties simultaneously, andrequirements for firms to make immediate public announcements of importantevents.Note: While not discussed in the text, many public companies have blackoutperiods surrounding earnings announcement dates, during which employees are not allowed to trade in company stock.8. a. Managers may withhold bad news:• To conceal evidence of shirking, if the bad news results from lowmanager effort.•To delay a fall in share price, which would increase cost of capitaland possibly affect manager compensation.• To enable insider trading profits.• To postpone damage to reputation.b. The disclosure principle will completely eliminate a manager’s incentive towithhold bad news if the following conditions hold:• The information can be ranked from good to bad in terms of itsimplications for firm value.• Investors know that the manager has the information.• There is no cost to the firm of releasing the information.• Market forces and/or penalties ensure that the information released is truthful.• If the information affects variables used for contracting (e.g., share price or covenant ratios), release of the information does notimpose increased contracting costs on the firm.Then, the market will interpret failure to disclose as indicating the worst possible information. To avoid the resulting impact on share price, all but the lowest-type manager will disclose.If one or more of the above requirements is violated, the disclosure principle may not completely eliminate the withholding of bad news. This will be the case when:• The information is proprietary. Then, there is a threshold level below which the news will not be released (Verrecchia (1983)).• If the market is not sure whether the manager has the information, there is a threshold below which the news will not be released,even though it is non-proprietary. The motivation to release non-proprietary information arises from its effect on firm value (Pae,2005).•When GAAP quality is not too high, information that goes beyond mandated information disclosure will only be disclosed voluntarily ifit exceeds a threshold (Einhorn, 2005).• If release of information may trigger the entry of competitors, the firm may only disclose a range within which the news lies. In thissense, disclosure is not truthful (Newman and Sansing (1993)).• If contracts, such as manager compensation, are based on share price and if releasing the news will increase the firm’s contractingcosts (e.g., a forecast’s effect on share price may swamp the abilityof share price to reflect manager effort), it may not be in the firm’sinterests to release the information (Dye (1985)).We may conclude that while the disclosure principle has the potential to motivate full release of bad news, in practice it is only partially effective due to the number of scenarios where it breaks down.9. a. The market declined because the announcements of lower sales andprofits contained market-wide information. If sales and profits were lower forthese two large and diverse firms, this suggests that many other firms will alsosuffer from reduced business activity. As investors bid down the share prices of all firms deemed to be affected by this reduced activity (including Coca-Cola and Xilinx), the market index was dragged down.Note: An alternative, less satisfactory, answer is that only the share prices of the two companies in question declined in reaction to the firm-specific informationcontained in the announcements. Since these firms are quite large, and are part of the market index, the decline in their share prices pulled the market indexdown. The magnitude and breadth of the market decline seems inconsistent with this argument, however.b. This episode illustrates the problem of externalities. The informationreleased by Coca-Cola and Xilinx about their own prospects also containedimplicit information about the prospects of other firms. The 2 companies receive no reward for this economy-wide information, consequently there is no incentive for them to release more than a minimum disclosure. For example, perhaps more timely release, more information about why they felt sales and profits will decline, having their auditors attest to the information, and/or breaking the sales andprofits down by company line of business or division, would have helped themarket to assess the extent to which other companies would be affected.11. a. Other suggested reasons for the decline in Canadian Superior’s shareprice:x The disclosure principle. The CEO’s refusal to answer questions may have led investors to conclude he had something to hide.x The sale of $4.3 million of his shareholdings by the CEO. This sale took place in January. The market should have largely reacted to it then.However, the March announcement may have suggested to the marketthat this insider sale was more ominous than it had perceived at the time.If so, a further share price decline would be expected.x Lawsuits. Concern about unfavourable outcome of the class action lawsuits would lead to a share price decline.b. The CEO’s sale of stock in January, 2004, suggests the adverses election problem, leading to insider trading. The adverse selection problemoccurs when an individual exploits his/her information advantage over otherpersons. Here, a possible explanation of the January stock sale is that theCanadian Superior CEO had inside information about El Paso’s intention to pull out of the project. Sale of shares before the market became aware of this6intention constitutes exploitation of this information at the expense of outside investors.c. The effect would be to decrease share prices of all Canadian oil and gas companies. This is an example of an externality. That is, share prices of other firms are affected by the actions of one firm.Share prices of all firms are affected because of a pooling effect, which takes place when investors are unable to discriminate between high and low-type firms. In effect, oil and gas shares are viewed as lemons, subject to considerable estimation risk.As a result, investors feel that the market for oil and gas shares is not a level playing field due to the large amount of inside information in the exploration for oil and gas and the apparent willingness of at least some insiders to exploit this information. Consequently, investors will withdraw from the market or reduce the amount they are willing to pay for all oil and gas shares.d. Possible signals include:x Obtain a new partner. A new partner will conduct due diligence about Canadian Superior’s prospects before investing. This willcredibly signal Canadian Superior’s willingness to subject itself tothe investigations conducted by the potential investors/partners,since it would not be rational to submit to such an investigation if thecompany believed the well’s prospects were poor.x Raise private financing and complete the well without another partner. This is a credible signal for the same reasons given in theprevious point.x Issue public debt, as a signal that management believes that the probability of the debtholders taking over the firm in the future islow. Management would not be rational to issue public debt if it feltthe well’s prospects were poor.x Management could increase its shareholdings, or amend the firm’s compensation plan to require more share holdings by seniorofficers. Increased shareholdings would not be rational ifmanagement was concerned about future firm performance.x Adopt more conservative accounting policies. This will signal thatfuture earnings can stand resulting downwards pressure. It wouldnot be rational to adopt conservative policies if Canadian Superiormanagement believed this would decrease any earnings-basedbonuses or increase the probability of future debt covenantviolation.x Hire a prestigious auditor. This signal may not be as effective asothers since the auditor may not be experienced in auditingtechnical details of oil and gas exploration. However, the auditormay be able to offer systems advice and implementation, to reducethe likelihood of future abuses of inside information.x Increase dividends and/ or undertake a stock buyback. Thesesignals may not be effective because they could also be consistentwith the company having little use for its cash in its own operations.12. a. The executive share purchase conveyed favourable inside informationabout the future prospects of the company. Yes, the purchase constituted acredible signal, as evidenced by the strong market response. Investors believed that it would not be rational for the Imax executives to buy these shares unlessthey believed the company’s future prospects were favourable.b. The market failures are adverse selection and moral hazard. It seems thatdespite their 2004 share purchases, Imax managers adopted accounting policies to overstate earnings, thereby compromising the interests of debtholders andshareholders (adverse selection). By overstating earnings, management mayhave also been attempting to cover up shirking (moral hazard). These policiesconstitute market failures because information about actual profitability wasretained as inside information, resulting in the overstatement of Imax share price for several years.c. Reasons why management bought sharesx They may have felt that Imax shares were undervalued by themarket in 2004. The earnings management that took place duringthis time could be interpreted as an attempt to report whatmanagement felt was Imax’s persistent earning power.x Management may have been low type (i.e., they expected thatfuture firm prospects were unfavourable) but were willing to pay theextra cost to signal high type. Perhaps they had plans to sell theshares later as share price rose due to the earnings managementand consequent higher reported profits. Perhaps higher share pricewould increase their compensation.x Management may have wanted to increase its motivation to workhard, to pull the firm out of deteriorating operating performance.Increased share holdings would supply additional motivation.13. a. Reasons to voluntarily expense ESOs:x Signal. The bank may have wished to credibly signal its expectation of increased future profits and/or the low persistence of its problemswith loan losses. If it expected its future profitability to be low, itwould not be rational to further force down profits by expensingESOs. Lower profits could affect executive compensation, debtcovenants and, for a financial institution, capital adequacy ratios.x Low usage of ESOs. The bank may have reduced its usage ofESOs following the financial reporting scandals of the early 2000s,where it appeared that increasing the value of ESOs was adriving force behind opportunistic manipulation of financialstatements. To the extent that ESO use is low, the effect ofexpensing on reported profits is low.x Commitment to openness and transparency in financial reporting.Given the impact on investor confidence of accounting scandalssuch as Enron and WorldCom, which affected share prices of allfirms, TD may have felt that voluntary expensing of ESOs will helpto improve its reputation for transparency and full disclosure,thereby reducing estimation risk, increasing public confidence and,presumably, increasing its share price.x Anticipation of new standard. TD may have felt that it was only a matter of time until ESO expensing became part of GAAP, so itmight as well start now.b. Costs of a standard requiring ESOs to be expensed:x Out-of-pocket costs. All firms would have to develop the ability and data needed to estimate ESO fair value, or hire experts to do it forthem. Costs would include estimating the parameters ofBlack/Scholes or other valuation model, and analyzing pastexercise behaviour so as to determine a distribution of times toexercise.x Loss of ability to signal. Firms that may wish to signal futureexpected profitability, transparency, and a commitment to fulldisclosure would not be able to do this via voluntary ESOexpensing.x Lower reliability. To the extent that estimates of ESO cost are unreliable, reported net income will be less reliable relative to itsreliability if ESO cost is reported in the notes.x Compensation contract efficiency. To the extent that expensingESOs causes firms to reduce their usage, and to the extent thatESOs are an efficient compensation device, firms will have tosubstitute other, possibly less efficient, types of compensation tomotivate performance. This would increase compensation and/oragency costs.Note: A counterargument is that ESOs were not an efficientcompensation device, since they often seem to have motivateddysfunctional manager effort rather than increased effort—seebenefits below.B enefits of a standard requiring ESOs to be expensed:x Greater relevance. Expensing of ESOs increases the relevance of financial reporting, since lower reported profits anticipate lowerper share dividends. Dividends per share will be lower because ofthe dilution of shareholders” interests that results when shares areissued at less than market value.x More efficient compensation contracts. Firms may reduce their usage of ESOs since it would now be necessary to record theirestimated cost as an expense. To the extent that ESOs encouragedysfunctional manager behaviour, substitution of other moreefficient compensation devices will increase productive managereffort and lower compensation costs.x Level playing field and lower estimation risk. Investors will have greater confidence in financial reporting to the extent they perceivestandard setters responding to past abuses of ESOs by requiring allfirms to report their cost.x Investors not fully rational and securities markets less than fully efficient. To the extent they are not fully rational, investors may notnotice ESO expense disclosure in the notes (e.g., limited attention).Since ESOs are a valid expense, they may thus overestimate firmprofitability, leading to overstated share price. They are more likelyto take notice of the expense if it is included in the financialstatements proper. This will reduce the cost of any bad decisionssuch investors may make.14. a. Tom Jones will shirk more as a majority shareholder because prior togoing public he bore all the costs (reduction of firm value due to shirking) himself as the owner-manager and suffered the loss in profits alone. That is, the effects of shirking were internalized. Subsequent to the new share issue, he will not bear all the costs – the minority shareholders will bear their proportionate share. Thus, shirking costs Tom Jones less after going public, so, other things equal, he willengage in more of it.Yes, the amount received for the new share issue will be affected. Potentialinvestors will be aware of Tom’s increased incentive to shirk after the share issue and will bid down the amount they are willing to pay for the new issue by theirshare of expected costs of shirking.b. Steps that Tom could take to convince shareholders that he will notengage in excessive shirking:x Tom could hire an auditor, or increase the work done by the current auditor. This will increase the credibility of future reported profits, and helpensure that the effects of shirking, including excessive perquisiteconsumption, are not hidden by earnings management.x Tom could increase the proportion of his compensation that depends on earnings and share price performance, to increase alignment with the newshareholders’ interests.x Tom could improve disclosure in the XYZ financial statements, so as to signal a commitment to fully inform outsiders about firm performance andprospects. For example, he could voluntarily issue a forecast of future profits, so as to credibly inform the new shareholders of his expected level16. a. The most likely reason is that Air Canada wanted to avoid a large decline in its stock price if its quarterly report revealed unexpected bad news. By releasing the information early through analysts that were obviously “friendly,” the company may have felt that by “talking down” the analysts they would diffuse or water down the bad news. This would reduce share price volatility.An alternate reason is that Air Canada’s management may have felt that releasing the information early, even though it was bad news, would enhance its reputation for full information release on the securities and managerial labour markets. This would favourably affect Air Canada’s cost of capital and management’s reservation utility, helping to counteract the effects of lower earnings.b. One reason why Air Canada’s share price fell is that the market was reacting to the bad news of lowered earnings forecasts.A second reason is that the selective disclosure had the opposite effect from what Air Canada had expected. By revealing inside information to a select group, investors felt that the market for Air Canada shares was not a level playing field. The resulting drop in market depth and increase in bid-ask spread lowered share price.A third reason is that the market as a whole may have dropped on those days, pulling Air Canada’s share price down with it. The problem does not give sufficient information to determine the extent to which this was the case.Finally, the market may have anticipated the fines and legal costs that would result if the disclosure violated Canadian securities legislation.c. The market does not work as well as it might with selective disclosure. Selective disclosure increases investors’ estimation risk and their perceptions that the market is not a level playing field. The resulting is a decrease in market liquidity, with negative effects on share prices, firms’ costs of capital, and the efficiency of capital allocation in the economy.d. This trade suggests adverse selection. A possible reason for the huge block sale is that an insider is taking advantage of inside information about expected future earnings of Air Canada.e. Air Canada should have been charged regardless. The problem is one of perception. Investors do not know whether or not the selected analysts used the information for personal gain. But, the possibility existed. Thus investors do not regard the market as a level playing field. This causes harm to the operation of the market. Air Canada’s selective disclosure policy, even if the analysts did not personally take advantage of the information, is the source of this harm.20. a. Costs to firms that issue quarterly earnings forecasts:x Direct costs of preparing the forecast. However, these costs are likely to be incurred regardless of discontinuance, to the extent the firm forecastsfor internal use.x Earnings forecasts may reveal proprietary information of value tocompetitors, since they convey management’s expectations about futureoperations.x Issuance of quarterly earnings forecasts may lead to a short-termmanager decision horizon whereby longer-term activities are sacrificed inorder to meet the short-term earnings objectives. Examples include cuttingof R&D and postponing capital expenditures.x Possible lawsuits if earnings targets are not met.x Managers may engage in opportunistic earnings management in order to meet earnings targets. This will harm the firm through lower share price(and the manager through lower reputation) when the earningsmanagement is discovered.b. Benefits to firms that issue quarterly earnings forecasts:x Lower estimation risk, leading to greater investor confidence, an increase in the number of investors in the firm’s shares, and lower cost of capital.This benefit is predicted theoretically by Diamong and Verrecchia (1991),and Easley and O’Hara (2004).x Motivation of managers to work hard to meet laid-down earnings targets.x Greater analyst following, leading to increased investor interest. Lang and Lundholm (1996) found that high quality disclosure was accompanied by a larger number of analysts following the firm. The theoretical model ofMerton (1987) then predicts greater demand for the firm’s shares leadingto lower cost of capital.x Earnings forecasts have signalling properties, thereby providing a credible vehicle for managers to communicate their earnings expectations. Thecredibility of a forecast derives from the fact that its accuracy can bereadily verified after the fact. Consequently, a low type firm would befoolish to issue a high type forecast.c. Reasons why the market penalizes the share price of firms that do not meet their earnings targets:x Investors revise downwards their probabilities of good future firm performance. This downward revision triggers sell decisions, leading to adecline in share price.x Investors know that managers have strong incentives to meet earnings targets, and have a variety of earnings management devices to assist inmeeting them. If the manager cannot find enough earnings managementto do this, the firm’s earnings outlook must be bleak.x Failure to meet earnings targets may suggest poor management in the sense that management may not be able to accurately predict the firm’sfuture.Investors must have known that management had the earnings forecast information, since this was released in the past and presumably would be continued for internal purposes. Consequently, the disclosure principle must have failed due to costs of disclosure, outlined in part b. According to Verrecchia(1893), Pae (2005), and Einhorn (2005), disclosure costs create a threshold. To be released voluntarily, information must be sufficiently good news that it exceeds the threshold. In view of the high costs of failing to meet earnings forecasts, management must have concluded that no matter how good the forecasted earnings might be, the costs were sufficiently high that the threshold was not exceeded.d. Reasons for use of real variables rather than accruals to manage earnings:x Managers may be afraid of reputation damage, legal liability, and possible jail sentences for accrual-based earnings management.x Accruals reverse. This makes earnings in future years increasingly difficult.x Short decision horizon. If the manager has a short decision horizon, he/she may not be concerned about the longer-term consequences ofcutting R&D and marketing costs to meet earnings targets.x Use of real variables frees up working capital, whereas accruals (except for possible tax effects) do not affect cash flows.。